When and why to sell a stock short; short selling strategies and examples (Pt 2)

cosmic speculation - short selling

Welcome to part two of my blog when and why to sell a stock short which gives a good fundamental analysis of short selling stock.

Short selling strategies

Short selling strategies are used in speculation, hedging, arbitrage and ‘against the box’ strategies. Many investors believe that a good combination of short and long positions on stock is beneficial to your stock portfolio.

The first three strategies are quite simple and i have sourced some definitions from wikipedia below. The final against the box strategy is more interesting and I tried to give a clear outline of it myself:

Speculation

A seller intentionally takes on the risk of the stock moving up or down in price in the belief that the value of the shorted stock will fall. An example of this is short selling the stock of a company before its earnings reports are released if you believe the reports will fall below the expectations of market analysts.



Hedging

Short selling often represents a means of minimizing the risk from a more complex set of transactions. Examples of this are:

  • A farmer who has just planted his wheat wants to lock in the price at which he can sell after the harvest. He would take a short position in wheat futures.
  • A market maker in corporate bonds is constantly trading bonds when clients want to buy or sell. This can create substantial bond positions. The largest risk is that interest rates overall move. The trader can hedge this risk by selling government bonds short against his long positions in corporate bonds. In this way, the risk that remains is credit risk of the corporate bonds.

Arbitrage

A short seller may be trying to benefit from market inefficiencies arising from the mispricing of certain products. An example of this is:

  • an arbitrageur who buys long futures contracts on a US Treasury security, and sells short the underlying US Treasury security.

Against the box

One variant of selling short involves also using a long position. “Selling short against the box” is defined as holding a long position and entering a short sale order on the same stock.

The purpose of this technique is to lock in the paper profits on the long position collected so far without having to sell that position (and possibly incur taxes if the position has appreciated). Whether prices increase or decrease from this point, the short position balances the long position and the profits are locked in minus the brokerage fees and short financing costs.

The term box alludes to the time when a safe deposit box was used to store (long) shares.

7 thoughts on “When and why to sell a stock short; short selling strategies and examples (Pt 2)”

  1. Pingback: Blogsvine
  2. James, nice post. Your description of the ‘against the box’ strategy is pretty interesting. In regards to your previous post, can you clarify what you meant by the ‘uptick rule’?

  3. Basically, The previous trend of the stock price has to be up. Thus if the stock price is falling, you cannot short a stock. You can only short a stock when the previous ‘tick’ or change in the stocks price has been positive or equal.

  4. These are short term strategies for traders rather than investors. I think you would have to have a lot of time to research and analyze the market to be successful. Nice post =)

  5. Hey, just stumbled across this blog and there’s some gr8 stuff here. Nice going.

    Kimsta’s right, shorting is for traders and if you ain’t a trader then you better steer clear of this stuff, coz you’ll just burn your cash. Unless of course you start learning about it and put it into your investing plan. Just be warned that heaps of people ahve lost cash by not trying trading strategies without having the knowledge and no tspending the time to watch the market.

    I dunno if it’s kocha to mention other sites, so feel free to censor, but there’s a great free shares site I use that has a few articles on the uptick rule and short selling:

    Short selling:
    http://www.compareshares.com.au/derk18.php
    http://www.compareshares.com.au/expert_CFDs10.php

    Uptick rule:
    http://www.compareshares.com.au/expert_forex9.php

    Flick

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